The Story Behind the Numbers

The Federal Reserve commanded center stage this week, holding its regular policy-setting meeting and delivering on its highly-telegraphed promise to reveal the interest rate forecast of the 17 members of the Federal Open Market Committee over the next three years. Chairman Ben Bernake has long been an advocate of more transparency in the policy making process; this week, he followed through in spades, particularly with the remarkable honesty and openness with which he conveyed his thoughts in the press conference following the FOMC meeting. True, nothing terribly exciting or surprising came out of the policy session, but the markets nonetheless drew comfort just from the reaffirmation that the Fed will be keeping rates at rock-bottom levels over the foreseeable future, and stands ready to take more action if the economy falters.

Although not a surprise, the Fed formally revealed its intention to keep interest rates at its current near-zero level through at least late 2014. That's more than a year beyond the guidance it had previously announced, which extended through the middle of 2013. Not all of the Fed officials agreed with this timetable. When asked when the first rate hike would occur, six projected a policy firming before 2014 and six thought that it would happen later, with four looking to pull the trigger no earlier than 2015 and two in 2016. These projections, of course, are contingent on the economy's performance. Make no mistake, should the pace of growth, job creation and inflation deviate significantly from expectations, the Fed will act accordingly, lifting rates sooner or later than the given timetable. The point is, these interest-rate projections are just that - projections, not commitments.

As the table presented after the FOMC meeting shows, the Fed does not have high hopes for the economy over the next year or two. It actually revised lower its growth forecast for 2012 and 2013 from the one presented in November, although it also lowered its expectation for the unemployment rate. Overall, the Fed was slightly more upbeat about recent economic data, saying that the economy was "expanding moderately, notwithstanding some slowing in global growth". But it remained very cautious about the outlook, pointing out in its policy statement that, "While indicators point to some further improvement in overall labor market conditions, the unemployment rate remains elevated. Household spending has continued to advance, but growth in business fixed investment has slowed, and the housing sector remains depressed. Inflation has been subdued in recent months, and longer-term inflation expectations have remained stable." The Statement also said, "Strains in global financial markets continue to pose significant downside risks to the economic outlook."

We were particularly interested in the Fed's views on inflation, both the outlook and the constraint it would impose on future policy decisions. As noted, it expects inflation to moderate next year and beyond, saying it " anticipates that over coming quarters, inflation will run at levels at or below those consistent with the Committee's dual mandate" which is to promote price stability and maximum employment. What does it consider to be price stability? For the first time, the Fed gave a specific goal of 2 percent as the desired long run inflation rate, as measured by the personal consumption deflator. In the fourth quarter, the PCE deflator stood 2.6 percent above the level of a year earlier, but the pace slowed sharply over the second half of the year. Compared to the third quarter, the deflator increased by a 0.7 percent annual rate. As the above table shows, the Fed expects the PCE deflator to increase between 1.4 and 1.8 percent in 2012.

From our lens, the Fed's moderating inflation outlook combined with its belief that unemployment will remain unacceptably high in coming years opens the door for another round of quantitative easing. To be sure, Bernanke was cautious in the outlook for further accommodation in policy. But in the press conference following the FOMC meeting, he was specific in that the Fed would undertake more asset purchases "if warranted," although such action was not yet decided upon. He said he was "not ready to declare" the economy had entered a new, stronger phase" and that the FOMC was "prepared to take further steps if the recovery is faltering." Another round of asset purchases was "certainly on the table," and added that, "if conditions warrant, we will certainly consider using it."

Interestingly, Bernanke's guarded assessment of the economy may have seemed overly cautious a month or so ago when most indicators showed increasing vigor and pointed to a solid start to 2012. As a result of this apparent momentum, the odds seem to favor no further Fed action was needed to nourish the recovery. But incoming data over the past few weeks suggest that Bernanke may be correct in looking through the stronger data, believing they were more of a temporary blip rather than the start of a stronger growth trend. For example, the holiday shopping season did not live up to the heightened expectations promised by the blockbuster sales reported over the Black Friday weekend. Excluding autos, retail sales in December actually declined for the first time since May of 2010. Meanwhile, conditions in Europe deteriorated significantly, with knock-on effects on U.S. exports. Housing remains in the doldrums, with a slight uptick in starts and homebuilder sentiment offset by continued softness in sales and home prices.

As it turns out, the first snapshot of the economy's fourth-quarter's performance was somewhat disappointing. The Commerce Department released its advance estimate of GDP on Friday, and the result was weaker than expected. During the period, the economy grew at a 2.8 percent annual rate, a tad below the consensus forecast of a 3 percent growth rate. For the year as a whole, real GDP increased by 1.7 percent, down from 3.0 percent in 2010. By itself, the slowdown is not out of the ordinary, as the first full year of a recovery is usually the strongest, benefiting from a bounce-back from recession. But the first-year rebound was anemic by cyclical standards and the second-year slowdown merely highlights the sub-par nature of this ongoing recovery. The 2.8 percent growth rate in the fourth quarter does not even equal the economy's long-term growth trend of 3 percent.

The disappointing headline reading on GDP sounded a negative chord in the financial markets on Friday, adding to the downbeat news coming from overseas. But more than the headline, the details of the GDP report were particularly disturbing to those in the optimistic camp. Simply put, most of the gain in the fourth quarter came from a $58 billion inventory buildup. That contributed fully 1.94 percent to the overall 2.8 percent GDP increase. Excluding this volatile category, real final sales rose at an anemic 0.8 percent annual rate, the weakest since the first quarter of the year. Dragging down growth, business investment slowed considerably and government spending on both the federal and state and local levels posted outright declines. The Federal retrenchment was entirely in defense spending, which slumped by 12.5 percent and seems to have been related to the pullback of troops from Iraq. State and local spending fell by another 2.6 percent, marking the fifth consecutive quarter of falling outlays.

Aside from inventories, the biggest contribution to the GDP gain came from consumers. But even here, the news is not that encouraging. During the period, personal consumption increased at a 2.0 percent pace, better than the 1.7 percent and 0.7 percent increases posted in the third and second quarters, respectively. But the lion's share of the gain was for autos, which spurred a 14.8 percent advance in durable goods purchases. That's not a sustainable trend, as it reflects primarily a rebound from the summer when auto parts were in short supply due to the Japanese earthquake. In the much larger services sector, which accounts for 64 percent of total consumption, outlays increased by only 0.2 percent, the smallest gain since the third quarter of 2009. Keep in mind that the service sector is also the largest source of employment, so a slowdown here is not auger well for the job market.

What's more, the modest pick-up in personal consumption was driven largely by an increased usage of consumer debt and a pullback in the savings rate. We would feel more comfortable if spending was supported entirely by growing wages and salaries, with some left over to build up savings and repay debt. Since just the opposite took place in the fourth quarter there is a good chance that households will slow their spending in the first quarter, which more than anything will restrain growth during the period. We suspect that the potential for a consumer retrenchment weighed heavily in Bernanke's cautious assessment of economic prospects in coming quarters. The chairman has often expressed concern with the condition of household balance sheets, which are still highly leveraged.

We concur with that assessment, but are encouraged by two developments in the fourth quarter that may limit the extent of a spending pullback. First, the aforementioned slowing in inflation means that households got more bang for the buck for every dollar of income earned. Real disposable income increased for the first time since the opening quarter of last year, rising by 0.8 percent. That's not much, but the underlying trend in nominal incomes is also rising. Moreover, a greater share of the increase is coming from wages and salaries and less from government subsidies. Excluding transfer payments, real disposable income rose by a solid $60 billion, following a decline of $23.2 billion in the third quarter and a small $3.1 billion increase in the second quarter.

Simply put, the economy received a big lift from inventories last quarter, which is not likely to be repeated in the current quarter. That alone strongly suggests a pending slowdown in GDP during the opening months of the year. However, some of the drags that occurred last quarter should not be as severe, such as the eye opening drop in defense spending. It should also be noted that housing made a modest contribution to growth in the fourth quarter, which supports the notion that the long and pernicious drag from the residential sector is over. Another positive omen: while business investment spending slowed in the fourth quarter, it picked in the closing month of the year. Both new orders and shipments of nondefense capital goods, excluding aircraft, posted solid gains in December according to a government report released this week. No doubt, this week's data poured some cold water on the more optimistic expectations that had been building a few weeks ago. We suspect, however, that the fundamentals continue to improve and will support a decent growth rate in the neighborhood of 2 ½ percent this year. Unfortunately, that's not enough to significantly lower unemployment and, if inflation continues to recede as expected, the odds favor more Fed intervention in the foreseeable future.